Looking for Leverage
Help clients determine funding sources for small multifamily investments.
Small apartment properties can be an excellent way for
first-time investors to enter the commercial real estate market. Apartment
properties with between five and 50 units are attractive investments because
there is less competition for them. Buildings with five and more units are
outside owner-occupied buyers' comfort zones and yet, large investors and
institutional investors tend to ignore these properties. Add to this the fact
that there are many more small properties than large ones, it is clear that the
opportunity to find undiscovered bargains is great in the small-apartment
However, a major problem is that maximum leverage, which
is more critical for small investors because of their limited resources, is
increasingly difficult to obtain in today's market. Though many lenders
technically permit up to 80 percent loan to value, financing amounts often are
limited to far below that level. This is because loan amounts not only are
restricted by LTV ratios, but also by debt service coverage ratio requirements.
In many markets today, capitalization rates are at historic lows, so DSC limits
are kicking in before LTV ratios. Typically lenders require that properties'
net operating incomes are at a ratio of 1.2 to 1 compared to debt service to
provide highly leveraged financing.
Finding FinancingHow can small investors find leverage in today's market?
The following techniques can help apartment buyers fund their investments in
properties up to $5 million. These techniques are available only with
small-apartment financing programs. Lenders in the small-loan arena have
developed these creative alternatives to attract small-apartment buyers'
Seller Carrybacks. Some innovative lenders allow sellers
to obtain mortgages that are not secured by the purchase property. Instead the
mortgages are secured by another property the buyer owns and the debt service
on the carryback is not included in the DSC ratio. For example, suppose a buyer
puts 10 percent down on an investment property and obtains a new first mortgage
of up to 80 percent LTV subject to 1.2 DSC ratio on the first mortgage only.
The seller carries 10 percent against one of the buyer's other properties such
as a small rental property, a commercial building, or even a home. In a case
where the first mortgage may be limited to less than 80 percent LTV because of
the DSC ratio, the seller's carryback is limited to 10 percent. This provides a
buyer with up to 10 percent more leverage than otherwise would be possible.
Seller Contributions. Some lenders allow sellers to
contribute up to 3 percent of the buyer's closing costs, thus reducing the
buyer's need for cash. The seller contribution typically only is allowed to
cover actual closing costs, such as points, appraisal fees, or title insurance.
These funds typically cannot be used as a repair credit, which for underwriting
purposes would reduce the purchase price by the amount of the credit.
Gifted Down Payment. A few lenders allow buyers to use a
financial gift from a family member for up to half of the down payment on an
investment. However, there are some restrictions. Specifically, the gift must
be from an immediate family member - either a parent, child, or sibling. The
gift funds must be verified via bank statements and/or a verification of
deposit and the source of the gift funds must be documented via canceled checks
and/or bank statements.
How does this process work? If a buyer is able to obtain
an 80 percent first mortgage and a 10 percent down payment gift, he or she only
needs 10 percent cash plus closing costs and required post-closing reserves,
which can be as little as two months' principal, interest, taxes, and
insurance, to purchase a property.
Mezzanine Financing. Mezzanine financing is finally
available to the small-apartment purchaser for acquisitions as low as $1
million. Under these circumstances, a lender generally makes both the first and
second loan. The first loan is limited to 80 percent LTV and a 1.2 DSC ratio.
The combined LTV of the first and second loans is limited to 85 percent, with a
combined DSC ratio of 1.07. Even in low cap-rate markets where the first
mortgage may be limited to 65 percent LTV or less, the mezzanine loan typically
can stretch a buyer's leverage up to 10 percent.
Equity Lines and Other Properties. When combined with a
new first mortgage, an equity line or lines of credit against other properties
a borrower owns is another way to obtain 100 percent of financing for an
investment property. Even though the payments for such lines of credit are not
included in the property's DSC ratio for underwriting purposes, the buyer
should take into account how he or she will service this additional debt.
Negative Cash Flow Programs. Several lenders offer loans
with DSC ratios of .90 or lower. In some instances buyers may be able to
purchase a property with negative cash flow. However, purchasers must be able
to verify that they have adequate income from employment or other sources. This
is typically done via W-2 forms, paycheck stubs, and tax returns for the
previous two years. A credit report also will be checked to verify a borrower's
monthly debt obligations to establish that he or she has an adequate personal
debt-to-income ratio when considering the negative cash flow obligation
incurred by the subject property.
It's important that commercial real estate professionals
carefully advise clients on their financing options for small-apartment
properties. While some of the previous strategies may be perfect solutions for
select clients, others may result in poor or negative cash flow if used
imprudently. All investors must have a clear understanding of the pros and cons
of any financing strategy before making a purchase decision.